Behavioural Finance - Part 2 - Emotional Biases

Behavioural Finance - Emotional biases

Jesse Jury (Mulcahy & Co Financial Planning) sat down with host Gavin Nash and Danny Archer (Partner – Financial Planning) to chat about this interesting topic. This is part two of the two part podcast series about behavioural finance. You can listen to part one on Episode 58 of the FS360 podcast.

Jesse is currently completing a post graduate course as a Chartered Financial Analyst (CFA) and this topic has been an interest area of his during this study.

Emotional Biases:

○     Harder to correct because they stem from impulses and intuitions.

○     They arise spontaneously rather than through conscious effort and may even be undesired to the individual feeling them.

○     Often possible only to recognise and adapt, rather than overcome.

Four common Emotional Biases when investing.

1. Loss-aversion bias: the tendency to strongly prefer avoiding losses as opposed to achieving gains (particularly taking more risk in an attempt to prevent losses).

○     Consequences (investors may):

■     Hold investments in a loss position longer than justified by fundamental analysis, in the hope that they will return to breakeven.

■     Sell investments in a gain position earlier than justified by fundamental analysis, out of fear that the gains will erode.

■     End up with a sub-optimal portfolio on a risk-adjusted basis due to this disposition effect.

○     Detection and guidance:

■     Show discipline in analysis and consider probabilities objectively (i.e. detach emotion from analysis & decision-making).

2. Status quo: choosing to do nothing instead of making a change, even when change is warranted.

○     Consequences (investors may):

■     Unknowingly maintain portfolios with risk characteristics that are inappropriate for their circumstances.

■     Fail to explore other opportunities.

○     Detection and guidance:

■     Quantify the advantages of diversification and proper asset allocation.

●     Regret aversion: avoiding making decisions out of fear that the decision will turn out poorly.

○     Consequences (investors may):

■     Be too conservative in their investment choices as a result of previous poor outcomes. Investors may wish to avoid the regret of making more bad investments and instead take on low-risk instruments, likely leading to long-term underperformance and failure to reach goals.

3. Engage in herding behaviour. Investors may feel safer in popular investments or by following other traders’ moves to limit regretting their own decisions (and instead blame others if a negative outcome occurs), or because they simply trust others more. Could also lead to choosing only familiar companies to invest in, despite unfamiliar companies potentially offering greater reward for risk taken.

○     Detection and guidance:

■     Quantify the risk-reducing and return-enhancing advantages of diversification and proper asset allocation.

■     Recognise that bubbles happen and keep long-term objectives and expected returns in mind.  

4. Endowment: valuing an asset more when one owns it than when one does not.

○     May be the result of multiple other biases, such as loss aversion, anchoring and adjustment, and overconfidence.

○     Consequences (investors may):

■     Fail to replace assets when prudent to do so.

■     Prefer to hold classes of assets with which they are familiar. Investors may believe they understand the characteristics of the investments they already own and may be reluctant to purchase those with which they have less experience. Familiarity adds to owners’ perceived value.

○     Detection and guidance:

■     When bequeathed securities, investors often cite feelings of disloyalty associated with the prospect of selling inherited securities, general uncertainty in determining the right choice, and concerns about tax issues.

■     Consider what course of action would be taken if the investor instead inherited an equivalent sum of cash.

■     Explore the deceased’s intent in owning the investment and bequeathing it, “was it to leave a specific investment portfolio, or to provide general financial resources?”

■     Estimate a minimum price at which the investor would be willing to sell and a maximum price at which they’d be willing to buy more (at a current point in time). If these do not match, there may be endowment bias.